Trump's tariffs cost less than an unbalanced China

Putting out the standard arguments against Donald Trump's tariffs without any context risks missing where the real dangers lurk. China is investing on a scale that has required a very large share of world markets.

This has been accompanied by a very casual attitude towards the rules of open trade and investment. The tariff war is a result of these developments and may well be a catalyst for bringing things to a head. But it is not clear that the tariff war is worse than letting imbalances continue to build – the secular trends are not sustainable.

Already some smaller Chinese banks and financial firms have been falling over. While the Chinese system won’t permit large market-driven financial collapses, the ferryman will still have to be paid. The price will be declining growth.

The ongoing trade spat between the US and China is a major risk for the world economy. AP

Since China does not consume much of its own GDP – indeed reducing its share of consumption over time – it has a non-negotiable need for a large share of world markets to stay afloat. This has led to a systematic breaking of the rules of open trade and investment since it joined the World Trade Organisation in 2001.

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There is a large amount of literature on disputes with China since joining the WTO —official, academic and judicial. Topic headings include: technology transfer requirements; violations of the Trade Related Aspects of Intellectual Property Rights (TRIPS), including IP theft, copyright infringement and counterfeiting; subsidies; State-Owned Enterprises (SOEs) that operate on non-commercial terms (including subsidised lending via SOE banks); use of taxation as a trade weapon; rare earth export quotas; import restrictions (including via technical barriers to trade); dumping; absence of national treatment for foreign banks and payment companies; non-participation in the Government Procurement Agreement in any meaningful way; and capital controls and related exchange rate manipulation techniques.

This long list has contributed to rapid Chinese penetration of other markets – particularly into the US, the most productive economy in the world. China’s import share of the US market rose from 8-9 per cent around the time of WTO entry to 20 per cent currently. This has occurred despite rising wages in China and a 20-30 per cent appreciation of the renminbi exchange rate.

Market access has been anything but a two-way street. Despite rapid Chinese growth, millions of people being taken out of poverty and the stronger RMB exchange rate, the US has seen its share of Chinese imports fall from 10-11 per cent at WTO entry to around 6 per cent currently.

Only countries that are vertically integrated into China’s near-term requirements have been able to take advantage – to date – of China’s need for speed. For example, Australia for resources and Germany for high-tech capital goods.

The US tariffs are an attempt to push China towards openness (a good thing) but may well be a catalyst in China’s secular slowing (a bad thing). How this unfolds in the near term depends on who will pay the main costs of the tariffs.

US consumers and companies do not yet appear to be net payers – which is fortunate because the current strength of the US economy is being driven by consumption.

Indexes of import prices from China and the RMB-per-dollar exchange rate are shown in the chart, alongside a calculation of the average tariff rate on US imports. Successive increments of tariffs and their coverage have seen the average rate rise to around 18-20 per cent (on about half of imports so far).

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Since the exchange rate affects 100 per cent of imports, the recent 9-10 per cent depreciation of the RMB has roughly offset the tariffs on average. Indeed, US import prices from China appear to be falling somewhat. China’s retaliatory tariffs will hurt US exporters, but these should have a limited effect on growth due to the small market share.

It is noteworthy that the 30 per cent appreciation of the RMB to 2014 had little impact on US import prices. This is indicative of the margin compression China is willing to absorb to maintain market share. If further depreciation is not an option in the event of Trump moving to tariffs on 100 per cent of Chinese imports, then margin compression and subsidies could come into play.

In sum, the impact of tariffs on the US thus far seems limited. If they are extended, margin compression for Chinese companies could follow, if depreciation is avoided, worsening the problem of falling returns due to over-investment.

If China chooses to use further depreciation, resource and energy imports will become more expensive for China, adding to slowdown pressure and hitting Australia’s exporters hard.

The tariffs come at an awkward time for China, which is approaching a secular turning point of its own making. This is the real danger in the global economy. Getting the rules-based open trading system sorted sooner rather than later – like financial regulatory policy prior to 2008 should have done – is essential for sustainable growth.

China needs to embrace openness and allow its consumption to rise towards (say) 80 per cent of GDP like other large countries; but giving up what it knows-and-loves may be a bridge too far. The alternative path, forced by an eventual financial crisis, would be a lot more costly.

Adrian Blundell-Wignall is a former director of the OECD, an adjunct professor at Sydney University.